The Bank of England is almost certain to raise interest rates this Thursday. How many more hikes will follow? Clear divergence between the market and economists.

According to Investing.com, as UK inflation approaches 4% and the Iran war shows no sign of ending, a rate hike by the Bank of England this Thursday is almost seen as a foregone conclusion. However, there are significant differences between economists and investors regarding how many more times the Bank of England will raise rates going forward.

In one scenario, after the Bank of England implements its first rate hike of 2023 this week, it will raise rates three more times before the end of next summer. The resilience of UK economic growth, stabilization of the labor market, and further deterioration of the energy shock in recent weeks are expected to force the Monetary Policy Committee to increase the bank rate to at least 4.75%—an outcome that has been priced into money markets since early September.

Another scenario—which is the economists’ consensus—anticipates a rate hike to 4% this week, followed by only a 50% chance of another rate hike by the first quarter of 2027. This judgment is supported by signs that consumers are beginning to cut spending and there is currently almost no evidence that the energy shock is causing a price feedback loop.

If policymakers oppose a prolonged tightening policy, UK government bonds may rise, especially short-term bonds whose yields have reached three-year highs. Another possibility is that the Bank of England may keep investors waiting for clearer signals about future rates, as current market pricing is already helping combat inflation by raising borrowing costs for households and businesses.

Significant Divergence Between Market Pricing and Economist Predictions

"Everyone has been expecting energy prices to decline and has based inflation and bank rate forecasts on this," said Paul Dales, Chief UK Economist at Capital Economics. "That's why economists generally don't expect too many rate hikes and anticipate rates will fall back. But the current environment is such that if energy prices remain at current levels for another six months or so, rates are likely to be higher."

Bank of America strategists point out that the gap between market pricing and the bank’s economists’ forecasts for the bank rate is 0.55 percentage points, one of the largest among major economies.

The Bank of England has stated that investors are demanding compensation for the increased risks around rate prospects, partly explaining the aggressiveness of the market curve. But even one of the most hawkish policymakers at the Bank of England, Chief Economist Huw Pill, has warned that he is "skeptical" about the need for four rate hikes.

Bank of America and Citigroup rate strategists attribute this gap to the following risks: energy prices continue to rise, the Iran war shows no signs of ending, and the UK economy remains stronger than expected. August’s GDP grew unexpectedly for the third consecutive month, suggesting third-quarter expansion far exceeds the Bank of England’s July forecast of 0.1%.

Elias Haddad, Global Markets Strategy Director at Brown Brothers Harriman, stated this makes the Bank of England’s communication around market pricing, as well as its corresponding forecasts for inflation and the UK economy, "key to assessing the room for further rate hikes after this week".

Bank of America strategists, including Mark Capleton, said that if the Bank pushes back against the “excessive” market pricing, the UK curve might undergo a "bull steepening", meaning the yields on short-end bonds would fall more relative to the long end.

A Decision “Without Surprises”

After last week’s first budget by UK Chancellor John Healey was largely digested by the market, the Bank of England may also hope for a decision without surprises this time. With markets expecting multiple rate hikes from the Bank of England, financial conditions have tightened, allowing the Bank to hold steady and lag behind the Federal Reserve and the European Central Bank.

However, policymakers know that expectations ultimately need to be supported or recalibrated by actions. Governor Andrew Bailey had previously poured cold water on market bets on multiple rate hikes in the spring, when traders priced in as many as four hikes.

Both Bailey and Deputy Governor Sarah Breeden have pointed out that there are signs businesses are cutting costs to cope with the energy shock, rather than passing price increases onto consumers. This occurred even before the Bank of England released its unexpectedly dovish private sector survey last week.

With consumers under pressure, many companies have found it difficult to raise prices, and so far, few surveyed executives plan to increase wages next year to counter the inflation shock, indicating that second-round effects are still limited for now.

“The Monetary Policy Committee may gently push back against market pricing,” said Danni Stoilova, economist at BNP Paribas. Policymakers "may use the tightening of UK financial conditions and limited evidence of second-round effects to justify taking a less aggressive path."